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May 17, 2013

Where are the Financial Geniuses?

Research Affiliates says firms seeking to find patterns of mispricing must encourage the critical evaluation of nonconformist ideas

A new investment commentary from Rob Arnott’s firm, Research Affilliates, proposes investment firms do their part to cultivate budding financial geniuses in their midst.

The unusual topic choice for its May newsletter may be par for the course for Research Affiliates. The firm is recognized for its outside-the-box approach to index construction.

Indeed, the firm has even been granted a patent for its methodology of weighting its indexes on the basis of investment fundamentals (as opposed to conventional weighting according to market capitalization).

So perhaps it is not suprising that the firm’s vice president of brand management, Phillip Lawton, would delve into a topic that reinforces the niche research firm’s market position and identity.

Lawton notes that financial geniuses are no more common than scientific geniuses like Einstein and Edison.

When a Harry Markowitz comes along and proposes modern portfolio theory and efficient markets hypothesis, or a William Sharpe develops his capital asset pricing model, their conceptual frameworks “have equipped several generations of investment professionals to…vastly increase the range of available strategies and instruments for taking on and laying off risk.”

But Lawton worries that the pace of financial genius could be mirroring a slowdown in the natural sciences, where the vast amount of knowledge required to reach the conceptual frontier has become harder than ever to attain.

Cracks are appearing in the prevalent view that markets are efficient, with much evidence, coming particularly from behavioral finance, that “flesh-and-blood investors are at best imperfectly rational.”

Progress in behavioral finance, “emotional finance” and neuroeconomics may eventually lead to new and improved valuation models.

But how can the industry help when some lack the time and energy to appraise new ideas and others eschew the career risk of nonconformist thinking?

“Can investment research teams accommodate inventors and iconoclasts? Can truly original thinkers function as members of a team?” Lawton asks.

The tendency of brainstorming sessions to lead to conformist thinking, the tendency of others to defer to higher-ups as well as inhibitions about sounding foolish in voicing novel ideas area all barriers to finding new patterns of mispricing.

Lawton proposes that investment managers counter these tendencies with a collegial atmosphere that incentivizes the critical evaluation of ideas, even seemingly outlandish ones.

The Research Affiliates exec—maybe because he works at Research Affililates—says he is optimistic that “a new, principles-based investment theory…is in the offing,” and predicts “it will emerge from the collective efforts of many gifted, accomplished, arguementative, sleep-deprived thinkers."